EC311 Study Guide Exam 1
Multiple Choice
Introduction, Chapter 1, and Articles
1. Important economic assumptions about individuals, firms, and markets.
2. Why study financial markets and institutions: enormity, breadth, and depth?
3. The importance of bond market, stock market.
4. What happens when stock market index rises and falls (due to higher/lower share prices)?
5. Basic understanding and assumptions of behavioral economics (from Ariely article)?
Chapter 2
1. The importance of financial markets to economic welfare.
2. Types and characteristics of financial instruments (money market, capital market instruments).
3. The role of transaction costs, risk sharing, and information costs in financial markets.
4. Types of contractual saving institutions, investment intermediaries.
5. SIX ESSENTIAL FUNCTIONS OF FINANCIAL MARKETS
6. Main reasons for government regulation of the financial markets.
Chapter 3
1. Three functions of money (describe each, examples).
2. Know what’s included in M1 and M2.
3. Electronic Means of Payment (EMOP): what is it, how big is it, what are some examples?
Chapter 4
1. Four Types of Credit Instruments: know the difference and examples of each.
2. Present value calculation (PV of a single payment in the future).
3. Yield to maturity: why it’s important and what it entails.
4. Present value of fixed-payment loan and coupon bond (just identify what is included in each calculation, don’t
have to actually do the long calculation).
5. Calculation of a zero-coupon bond or a consol (will look similar to problem 3 or 4 in your homework sheet).
6. General characteristics of bonds: relationship between default risk, maturity, and interest rate/price (“Maturity
and the Volatility of Bond Returns”).
7. Relationship (calculation) between real interest rate, nominal interest rate, and expected inflation (also, how
low/high real interest affect willingness to lend/borrow).
Chapter 5
1. Determinants of Asset Demand and relationship with each with quantity demanded of assets.
2. Supply and demand of bonds: equilibrium, excess supply and excess demand (when each happens).
3. Factors that Shift the Bond Demand Curve: Wealth, expected interest rate, and expected inflation.
4. Factors that Shift the Bond Demand Curve: risk and liquidity.
5. Factors that Shift the Bond Supply Curve: profitability of investment opportunities, expected inflation, and
government activities (deficit).
6. Fisher effect: cause, effect, and implication.
7. Keynes’ liquidity preference framework (two forms of wealth: money and bonds), relationship between money
supply and interest rate.
Chapter 6
1. Difference between interest-rate risk and default risk.
2. Difference between risk structure and term structure of interest rate.
3. The risk premium on corporate bonds: when it might increase/decrease.
4. Compare risks of corporate bonds, U.S. Treasury Bonds, and municipal bonds (pay attention to tax
considerations).
5. Default Risk and Liquidity on Corporate Bonds: How it’s affected by both the corporate bonds market and
Treasury bonds market.
6. Expectations theory, segmented markets theory, and liquidity premium theory: how each explains the empirical
facts about the risk and term structure of interest rate.
7. Calculate interest rates of a five-year bond by averaging expected interest rates over the time period (using
expectations theory and liquidity premium theory).
Essay/Problem
1.
(6 points) You buy a $1000 face-value, 30-year, coupon bond with 5% coupon rate for $500 [Chapter 4].
a)
What is the current yield of this bond?
b)
Suppose that you sell this bond next year for $510, what is the holding period return on this bond?
c)
Suppose this coupon bond has a default risk of 20% in the first year, meaning there is a 20% probability that
this bond will pay its annual coupon. How does this information affect the expected yield (modify problem a)?
2.
(12 points) Our author states that one of the essential functions of financial intermediaries is to "develop expertise in
monitoring the parties they lend to, thus reducing loses due to adverse selection and moral hazard." How is this
supposed to work, and does it work? [Chapter 2, under “Asymmetric Information” heading].
a) Briefly define/describe adverse selection and moral hazard problems.
b) Give an example for each, theoretical or practical, how financial intermediaries are supposed to mitigate adverse
selection and moral hazard.
c) In your opinion, how did the recent financial meltdown of 2008 show the successes, or inadequacies, of financial
intermediaries in performing said function? Provide an example or potential solution.
3.
(12 points) The Fisher effect explains the relationship between expected inflation and interest rates. It states that
“when expected inflation rises, interest rates will rise.” How does the following explain this theory? [Chapter 5].
a) How does the increase in expected inflation decrease the demand for bonds (shift it to the right)?
b) How does the increase in expected inflation increase the supply for bonds (shift it to the right)?
c) How do both factors affect the equilibrium price of bonds, and thus interest rates of bonds?